In contrast to the volatility in global
financial markets since the inception of the GFC, financial markets in Pakistan
have continued to strengthen primarily due to the low level of integration with
global financial markets, and in response to the ongoing reform process, and
provide requisite support to the financial system in performing its function of
financial intermediation.

Specifically, the functioning of the
money market in FY2010 gained strength from the ongoing policy measures and
supported both the SBP monetary policy stance and financial sector stability.
Although persistent increase in government borrowing from the banking system
resulted in intermittent pressures on market liquidity during the year, robust
deposit growth of the banking system partly offset the pressures.

The domestic foreign exchange market
also benefited by strong growth in worker remittances, marginal increase in
foreign investment flows, receipt of tranches of IMF loans and rising trade
activities in FY10. As a result, country's overall reserves reached a level of
US$ 16.9 billion by end-June FY10. These developments in turn allowed SBP to
continue to liberalize the foreign exchange market. The most important measure
on this front is the complete shifting of oil payments to the inter-bank market
by December FY10. This policy shift was supportive in containing a further drain
of SBP reserves. More encouragingly, the relative stability in the exchange rate
during FY10, despite shifting of oil related payments, is primarily a reflection
of the increasing depth of the inter-bank foreign exchange market.

Given the relatively gradual pace of
implementation of capital market reforms, the equity market has not proved
itself to be an avenue for raising funds and has operated more as a trading
platform. Not surprisingly, the significant volatility seen in CY08 and
subsequent gradual pace of recovery had little impact on financial stability,
given its limited role in meeting the financing needs of the economy, and the
bank-based structure of the financial sector.

The impact of the wealth effect however
cannot be ignored, as indicated by the decline in value of investments in
investors' accounts maintained with the Central Depository Company (CDC).

At the end of the day, an efficient
financial system is one which is diversified, and in which all components
function in meeting the financing needs of the economy. Not only does Pakistan's
economy continue to have an undue reliance on the banking sector, the emergence
of the government as the major user of bank credit has led to the crowding out
of the private sector even as the economy is headed towards a gradual recovery.

In the current circumstances, while it
may be prudent for banks to allocate their loan and investment portfolio in
favor of public sector to maximize profits in the short run and minimize risks,
a long term strategy requires an allocation of their portfolio in favor of the
private sector, which is the main engine of growth and productivity.

At the moment, the flow of bank credit
to the private sector remains hampered, and the basic objective of financial
intermediation i.e. efficient allocation of resources, is not being met. A
continuation of this trend, if not pre-empted and reversed on a priority basis,
will negatively impact financial penetration and depth which is already at a low
level.

GROWING NPLs CONCERNING BANKING SECTOR

The increasing concentration of loans
to the power sector at 9.5 per cent of total loans as of end-June CY10 is an
indicator of sectoral concentration. Notably, in periods of slow economic
growth, banks prefer to lend to better performing economic sectors, and within
these sectors, to strong corporate clients.

After the biggest ever increase in the
stock of NPLs in the year 2008 alone the pace of deterioration in the quality of
advances slowed down considerably in calendar year 2009, the Non-Performing
Loans (NPLs) increased by 24.2 per cent to Rs432 billion by end-2009, and
further by 6.4 per cent to Rs460 billion by end-June 2010.

Given the strong correlation of NPLs
with economic activities, a major portion of the increase in NPLs since 2008
calendar year was primarily of a cyclical nature due to the deceleration in real
GDP growth, with negative implications on incomes and hence the repayment
capacity of the average borrower. The gradual process of economic recovery has
had an impact in slowing down the accelerated pace of growth of NPLs in CY09.

Irrespective of the factors responsible
for the rising volume of NPLs, the high infection ratio has implications for the
overall financial performance of banks.

During CY 2009, banks booked Rs97
billion as loan loss expenses, lower than the amount of Rs106.1 billion booked
in CY 2008. This slight reduction is in line with the decelerated growth of NPLs.
However, these expenses carry implications for banks' profitability, especially
when majority of the outstanding NPLs 65.5 per cent are categorized in the fully
provided loss category. A substantial reduction in the proportion of initial
categories in gross NPLs indicate that in CY2010, the provisioning requirement
would fall, with a consequent positive impact on banks' bottom line.

The increased risk to the solvency
position is also visible from the surge in the net NPLs to capital ratio of the
banking system to 20.4 per cent, from 19.4 per cent in CY 2008, compared with
only 5.6 per cent for CY2007. (AB)